Paying Uncle Sam: From Tobacco To $1 Trillion

Despite the textbook pictures of European settlers sitting down to pumpkin pie with smiling Native Americans, the colonies in America fared miserably in the early years. The original colony in Roanoke was either destroyed or abandoned, and Jamestown and other "successful" colonies spent most of their formative years starving or eating rats, and eventually even eating the leather from the boots they had brought with them. Because these colonies were funded by venture capitalists, much of their produce, mostly tobacco, was sent back to England and sold with only some of the profits coming back in the way of much-needed supplies. This "payment" of tobacco from the settlers to their ruling empire became the United States' first form of taxation, but it wasn't enough for the British to take tobacco from the settlers, more was to come. Find out how we got from a couple crates of tobacco trillions of dollars Americans pay in taxes each year. (To learn how taxes got their start in the old country, check out Tablets To 1040s: How Taxes Began.)

The Costs of WarAs the American landscape was transformed into a more hospitable place for English-style industry, more and more people flowed in from across the sea. More people meant more economic activity, and the American colonies started to thrive. As Britain and the settlers considered the colonies to be British subjects, it was no great surprise when they were asked to pay a tax to help pay for the costs of the Seven Years War that Britain had waged on behalf of the colonies against the French.

The problem was that the government taxed them without giving the colonists a say as a political unit. 1765 was the year that the British subjects living in the colonies started to reconsider their allegiance. The rallying cry of, "No taxation without representation!" was yelled in response to the Stamp Act and the tax that was levied for repaying the war costs. (To read more about money and war, see War's Influence On Wall Street and Cold Hard Cash Wars.)

Americans RevoltHow deep did the greedy British dip into the pockets of the hard-working colonials? The tax total of the Stamp Act, the war repayment and the indirect tax on other goods amounted to about 2% per person. This 2% may have seemed trivial to British subjects, representation or no, but the Americans had enough. The coming revolution would rid Americans of any direct tax on their income - for now.

The U.S. constitution, as it was adopted in 1789, required that any direct taxes had to be split up among the states according to their proportional population. This meant that the citizens in different states would end up with different tax rates because the states varied in size. To avoid this difficulty, there were tariffs and excise taxes to help fund the government instead of direct taxation.

War = Death and TaxesFrom 1789 onward, the history of taxes in the United States was like the tides of the ocean; one administration would impose more, just to have the next administration roll them back. This cycle of ebbing and flowing tax rates continued through 1861, when it became necessary to finance the Civil War and income tax was imposed. It was during this time that the Bureau of Internal Revenue was formed by President Abraham Lincoln, which is now known as the Internal Revenue Service (IRS). This income tax, a direct tax that didn't follow the guidelines of proportionality set out in the constitution, expired without comment in 1872. (To learn more about income tax, check out 10 Steps To Tax Preparation, Do Tax Cuts Stimulate The Economy? and Common Tax Questions Answered.)

Without income tax, however, the primary source for government revenue was once again excise tax and tariffs, which yielded less revenue and led to a contraction of the government. In 1894, the Democrats pushed through income tax again in the hope of improving life in America through government programs and services. A tax of 2% was to be paid on income above $4,000. This income tax was challenged and ruled unconstitutional by the Supreme Court, so the Democrats set about changing the constitution. The Sixteenth Amendment was ratified in 1913, and permanently opened the door for income tax in the United States.

The Democrat and Republican Tug-of-War In the middle of World War I, income tax was changed into a progressive tax that bit deeper into above-average incomes. The new income tax was combined with a special excess profits tax for the purpose of redistributing the wealth from big business and the upper classes. The larger amount of tax being collected meant that the Bureau of Internal Revenue had to be reorganized and expanded. Corporations were required to give the Treasury Department - and, by extension, the Bureau of Internal Revenue - information about employee salaries, dividends and profits.

The Republicans regained power in 1921 and repealed many of the taxes, including the excess profits tax, as well as introducing deductions and preferential taxation on capital gains. This made investing the ideal way for people to grow what little money they were left with after taxes. Although the progressiveness of income tax was lessened, it was far from eliminated. During the Great Depression, taxes increased, but federal income tax was left alone because people were barely getting by as it was. The collection of state income tax, something that was not prevalent until the depression dried out state revenues, became more common and added to individual tax burdens. (Keep reading about this subject in The Greatest Market Crashes and The Stock Market: A Look Back.)

War, Death and TaxesWorld War II altered the tax environment in several major ways. Exemptions were eliminated so that very few Americans had no taxable income and then the tax rates were hiked up considerably. There were about 3.9 million taxpayers in the U.S. in 1939, compared to 42.6 million by 1945, owing mostly to the new system of payroll withholding. Corporations escaped the worst of it during the war, paying set tax rates on excess profits only. All in all, income tax from American citizens accounted for 40% of government revenues and the government was continuing to grow.

After the war, individual income tax was lessened with more deductions, exemptions and credits. Just as over-taxation seemed to be lessening, the inflation level of the 1960s and 1970s forced many people into higher tax brackets without increasing their purchasing power. Corporate taxes, because they weren't progressive, were unaffected. As a consequence, income tax once again made up the bulk of government tax revenue. Another consequence was that the investors who had moved their wealth into stocks also found that these worked as protection against inflation. (To find out more about inflation, read The Importance Of Inflation And GDP and All About Inflation.)

During this time, the expansion of government also continued. As more tax revenue came in, more public services and social programs were taken under government mandate, and more revenue was needed. This caused (or revitalized) a small anti-tax backlash over paying the government money for services that the some believed the private sector could better provide at a lower cost. The majority of people, the new middle class (bearers of most of the tax burden), did not join in, so the noise died down.

1980s Tax ReformThe 1980s saw the introduction of indexed tax rates meant to eliminate the problem of bracket creep. The 1980s also saw preferential treatment of capital gains taken away and then given back. One of the reasons that capital gains had been given preferential treatment in the first place was to reduce the burden on the Social Security system by encouraging individuals to plan for their own retirements. Economists often propose basic changes to the tax system like a flat tax on earned income or consumption-based taxes instead of income tax, but both these proposals run on the fault line of favoring either the rich or poor. Either way the government will continue to benefit, no matter which segment of the population bears the burden.

Taxes Are Here to StayLike it or not, taxes are here to stay. The first Americans rose up against taxes because they were paying too much with too little in return. American taxpayers now pay, on average, 28% more than the British ever did. However, we are far removed from the thinking that prevailed in Jefferson's time. The services the government provides, including those of education, law and security, are far from perfect, but most agree that they are badly needed. Because we need the government, we must also take on the unfortunate responsibility of paying for it.